In the previous lesson the working capital adjustment was explained in the context of an acquisition. In this lesson we will dive a little deeper into the calculation required by this adjustment and the documents that are exchanged in the process.
To better understand how the working capital adjustment works in a control private equity transaction, we first need to distinguish between the accounting definition of working capital and the definition of working capital for the purposes of a transaction. An accounting definition follows:
Working capital, also known as net working capital (NWC), is the difference between a company’s current assets, such as cash, accounts receivable (customers’ unpaid bills) and inventories of raw materials and finished goods, and its current liabilities, such as accounts payable. (Source: Investopedia)
In a transaction, the working capital adjustment revolves around a calculation of working capital that both parties must agree to. The primary differences are summarized in the bullets that follow and addressed in greater detail below.
- Cash is Excluded: Whereas the accounting definition includes all working capital accounts, here cash accounts are excluded from the working capital calculation.
- Not all Accounts are Included: Both the seller and buyer will need to agree on which current accounts should be included for the purposes of the working capital calculation. It should not be assumed that all current assets and current liabilities will be included.
- Certain Balances Can be Excluded: Beyond the decision to include any individual line items, the buyer and seller may agree to include or exclude only a certain amount of any particular account. We will elaborate on this later.
- Working Capital Must be “Normalized:” Finally, the seller and buyer will need to agree to a “normalized level of working capital.” A common example would be to take the average last twelve months of each working capital account included in the calculation.
Please download the PDF notes for detailed notes on the process outlined above..